Incentives for Corporate Tax Planning and Avoidance (10/17/12)

John R. Graham, Michelle Hanlon, Terry Shevlin and Nemit Shroff, Incentives for Tax Planning and Avoidance: Evidence from the Field (SSRN 9/12/12), here.

Abstract: 

We analyze survey responses from nearly 600 corporate tax executives to investigate firms’ incentives and disincentives for tax planning. While many researchers suspect that reputational concerns affect the degree to which managers engage in tax planning, this hypothesis is difficult to test with archival data because it is only possible to observe the firms that engage in tax planning and that get caught. Our survey allows us to investigate reputational influences and indeed we find that reputational concerns are important – 69% of executives rate reputation as important and the factor ranks second in order of importance among all factors explaining why firms do not adopt a potential tax planning strategy. We also find that financial accounting incentives play a role. For example, 84% of publicly traded firms respond that top management at their company cares at least as much about the GAAP ETR as they do about cash taxes paid and 57% of public firms say that increasing earnings per share is an important outcome from a tax planning strategy. Finally, we examine whether FIN 48 and SOX affected tax planning and relationships with auditors, as conjectured in prior research. Executive responses confirm these conjectures.

The following is from the introduction (footnotes omitted)

I. INTRODUCTION 

Recent evidence indicates that there is wide variation in the extent to which firms engage in tax planning and tax avoidance strategies as observed, for example, by the large differences in firms’ effective tax rates (ETRs). Dyreng, Hanlon, and Maydew (2008) report that over a ten year period, one quarter of the firms in their sample pay less than 20% of their pre-tax income in taxes while another quarter pay more than 35% – the top U.S. statutory income tax rate – of pretax income in taxes. The economically significant differences in effective tax rates raises the question of why some firms appear to engage in tax planning and avoidance while other firms show virtually no sign of tax planning. Although prior research discusses some of the incentives for firms to engage (or not engage) in tax planning, there is little empirical evidence of these incentives, likely because of difficulties in measuring tax planning strategies and managerial incentives using archival data (Hanlon and Heitzman 2010). 

In this paper, we examine the determinants of managers’ willingness to engage in tax planning strategies by directly asking tax executives about their incentives via a survey. The primary benefit of using survey methodology is that we gain direct insights about (stated) managerial motives, which are unobservable using archival data. Our intent is to conduct new tests, as well as complement and extend the predictions and evidence found in empirical-archival studies. Accordingly, we use prior literature as the basis for our survey questions and focus on research questions that are difficult to address with archival data or that have mixed and conflicting empirical evidence.  

[*2]  One of our goals with this paper is to examine the incentives and disincentives for firms to engage in tax planning and avoidance. Given the huge potential for reduction in tax expense and cash taxes paid to the government, the benefits for firms to engage in tax planning are clear. Yet, even in the face of such large potential benefits, it is not well understood why such large cross-sectional differences exist in the proclivity to tax plan. Furthermore, understanding the reasons why more firms do not actively engage in aggressive tax planning and avoidance is a puzzle – referred to as the “under-sheltering puzzle” (Weisbach 2002). Some have  conjectured that concerns about reputation cause some firms to limit tax planning. For example, Bankman (2004) suggests that a firm that aggressively avoids taxes may be labeled a “poor corporate citizen,” which might adversely affect product market outcomes. Hanlon and Slemrod (2009) attempt to test this hypothesis. The authors find some limited evidence consistent with reputational concerns being a viable disincentive to tax plan; they document a more negative market reaction to news of using a tax shelter for firms in the retail industry relative to firms in non-consumer products industries.4 However, in their study of 113 firms subject to public scrutiny for having engaged in tax shelters, Gallemore, Maydew, and Thornock (2012) find no evidence of a reputation effect in terms of CEO and CFO turnover, auditor turnover, lost sales, increased advertising costs, and decreased media attention. 

An important limitation of these prior studies is that they examine the reputational consequences for firms that were publicly identified as engaging in tax shelters and hence, their methodologies cannot account for the possibility that ex ante reputation concerns deter the firms (and strategies) that are most likely to face (cause) reputation penalties (i.e., whether reputation  [*3] concerns constrain tax planning is not measurable because strategies not employed on account of reputational concerns are not observed). Survey data are valuable in this setting because we can directly ask tax executives “why did your company not engage in a tax strategy.” Our survey results provide evidence that the potential for an adverse effect on company reputation significantly constrains firms’ incentives to engage in tax planning strategies, with 69% of our survey respondents (72% of publicly traded respondents) indicating that reputation concerns are ‘important’ or ‘very important.’ Indeed, concern about reputation ranks second only to the concern that a tax strategy might not pass the judicial standard of “business purpose/economic substance.” 

In addition to reputational concerns, financial accounting consequences are also thought to affect the decision of whether to engage in tax planning. There is a long literature on how tax planning is affected by accounting method and reporting choices (i.e., the book-tax tradeoff literature). In addition, recent studies suggest that tax departments are operated as profit centers (Robinson, Sikes, and Weaver 2010), tax strategies are engaged in with the goal of improving accounting outcomes (e.g., Desai and Dharmapala 2006), and tax policy responsiveness is constrained by accounting effects (e.g., Shackelford, Slemrod, and Sallee 2011). We extend this line of inquiry by investigating the extent to which tax planning strategies are used as a mechanism to increase financial accounting earnings. We ask managers 1) the frequency with which tax planning strategies are pitched to their firm (by accounting, law, investment or tax consulting firms) as a way to increase financial accounting earnings, 2) whether accounting  [*4]  concerns are important when deciding whether to engage in tax planning, and 3) about the tradeoff between cash taxes and financial accounting earnings per share in the context of tax planning.  

Our survey evidence suggests that it is fairly common to market tax planning proposals as a means to increase financial accounting earnings. Specifically, 32% of the firms in our sample (35% of the public firms) indicate that the tax planning strategies marketed to their firm were ‘always’ or ‘often’ marketed as a way to increase earnings. Further, we find that 61% of the surveyed companies (71% of the publicly traded companies) say that it is important that a tax strategy does not reduce earnings per share (EPS), and 49% (57% of public companies) respond that it is important that the strategy actually leads to higher EPS. The stated importance of financial accounting factors on the incentive to engage in tax planning that we gather from the tax executives provides direct evidence on the predictions and hypotheses about the interaction of financial statement effects and tax planning put forth in recent studies (e.g., Robinson et al. 2010; Shackelford et al. 2011; Graham et al. 2011; Hanlon 2012). In addition, the responses shed light on and provide some support for the claims in Desai and Dharmapala (2009a) that tax shelters are at times employed to improve accounting earnings. 

In addition to providing evidence on the influence of reputation and financial accounting concerns, another goal of our paper is to examine the effects of recent SEC and FASB regulations on 1) tax planning, and 2) on the role played by external auditors in corporate tax planning. Specifically, we examine whether the Sarbanes-Oxley Act (SOX) changed the role of auditors in tax planning and whether FIN 48 constrains tax planning. Traditionally, auditors had a significant effect on firms’ tax planning behavior because 1) they obtain much information during the course of the audit, allowing them to market customized tax strategies to firms, and 2) they develop strong relationships with the tax directors and CFOs of client firms. However,  [*5]  Maydew and Shackelford (2007) provide evidence that SOX significantly reduced the role played by auditors in corporate tax functions. Specifically, they find that the fees companies pay to their auditor for tax services declined significantly after SOX. The authors go on to conjecture that having an auditor that is distinct from the tax planning consultant is likely to lead to suspicion about sophisticated tax strategies, leading to increased tension between auditors and clients and decreasing aggressive tax planning. 

This conjecture has not been tested using archival data, likely because identifying any effect attributable to the separation of auditor and tax consultant/preparer is difficult in light of all the other potential effects of SOX. In an attempt to fill this gap, we use the survey to investigate the effect of SOX on tax planning and the tax planning environment, addressing the conjecture in Maydew and Shackelford (2007). Nearly three out of four surveyed firms indicate that their auditor and tax service provider are not the same firm. Moreover, among those with different audit and tax service firms, we find that 61%  split the provision of these services in response to SOX. We also find, consistent with the predictions in Maydew and Shackelford (2007), that 51% of the respondents who began using different audit and tax service providers due to SOX indicate that tensions between the auditor and the company have increased after separating the tax and audit functions. Finally, we find that 28% of the respondents (29% of the public respondents) who began using different audit and tax service providers due to SOX indicate that they would limit their tax planning because of the additional scrutiny from a service provider that is not their auditor. In contrast, only 11% of the respondents (10% of the public
respondents) who use different audit and tax service providers for reasons other than SOX indicate that they would limit their tax planning because of scrutiny from the auditor. This  [*6]  difference speaks to the effect of SOX on deterring tax planning. These findings provide the first empirical evidence on the predictions put forward by Maydew and Shackelford (2007).
Finally, we examine whether Financial Accounting Standards Board Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes – affects firms’ incentives to engage in tax avoidance. The expanded disclosure requirement in FIN 48 raised the concern of additional scrutiny from the IRS for tax positions disclosed as uncertain. We use our survey instrument to ask tax executives whether and why the implementation of FIN 48 would affect their tax avoidance behavior. Again, testing such a question with archival data is difficult because one would need to identify the effects of FIN 48 relative to other events occurring at the same time.  

We find that for 57% of the respondents, FIN 48 will cause (or has caused) them to reduce their willingness to take tax aggressive positions, while 39% state that FIN 48 had no effect on their tax planning behavior. Further, we find that the primary reason for firms to reduce their tax planning activities following FIN 48 is because the FIN 48 disclosure provides a “potential roadmap to the IRS” about firms’ uncertain or aggressive tax positions.  

Besides increased IRS scrutiny, financial statement and accounting auditor effects also significantly affect firms’ willingness to engage in tax planning following FIN 48. These effects include 1) the potential for increased scrutiny by the external auditor, 2) the increased risk of having to restate financial statements at a later date, and 3) an increase in volatility in the GAAP ETR. Because these data were gathered soon after FIN 48 was passed, future research can extend our findings by investigating whether the effect of FIN 48 changed over time. 

[*7] This paper contributes to the growing literature on the determinants of corporate tax avoidance and provides some explanations for why some firms do not engage in tax avoidance strategies. Importantly, this paper sheds light on the so-called under-sheltering puzzle proposed by Weisbach (2002). We provide evidence that reputational concerns are an important factor that limits the extent to which companies engage in tax planning. Our paper also contributes to the literature through our direct inquiry of executives about the effects of financial accounting. Tax executives in publicly traded companies state that in 47% of their companies top management values the GAAP ETR more than the cash taxes paid and in another 37% of public firms the two metrics are equally valued by top management. This evidence gathered from the companies via survey methodology provides some of the most direct evidence in the literature about how important accounting earnings are to companies with capital market incentives. We also contribute to a recent line of research that suggests that increasing financial accounting earnings is not simply a byproduct of tax avoidance but one of the goals of tax planning (e.g., Desai and Dharmapala 2009a; Shackelford, Slemrod, and Sallee 2011; Robinson, Sikes, and Weaver 2010; and Armstrong, Blouin, and Larcker 2012). While the traditional view based on Scholes and Wolfson (1992) is that the objective of tax minimization conflicts with managers’ incentives to report higher accounting earnings, Robinson et al. (2010) and Armstrong et al. (2012) find evidence that firms often view their tax departments as profit centers that devise tax strategies to generate incremental accounting earnings and lower GAAP ETRs. 

Finally, we provide evidence on the effects of recent regulatory changes – i.e., SOX and FIN 48 – on tax planning incentives. Because it is extremely difficult to identify the effects of  [*8]  these regulatory events using archival data and interrupted time-series tests, our survey evidence offers a methodology to obtain initial insights on the topic.

Students who are interested in this topic may also be interested in the following blogs regarding what I call BS tax shelters from my Federal Tax Crimes Blog:

• Thoughts on the the Corporate Audit Lottery (Federal Tax Crimes Blog 2/11/12), here.
• Second Circuit Strikes Down Another BS Tax Shelter (Federal Tax Crimes Blog 1/24/12), here.
• Altria # 4 - Second Circuit Declines Altria's Invitiation to Sustain a BS Tax Shelter (Federal Tax Crimes Blog 9/30/11), here.
• Altria #3 - What Were Those Guys Smoking? (Federal Tax Crimes Blog 3/23/10), here.
• Altria #2 - Economic Substance and Juries (Federal Tax Crimes Blog 3/22/10), here. 
• Altria # 1 - Frank Lyon and tax shelters (Federal Tax Crimes Blog 3/20/10), here.